Why things may be improving for ASX micro-caps – and 2 stocks on this fundie’s radar

The last financial year was a shocker for Australian micro-caps, particularly at the smallest end of the company spectrum, as shown in the table below.

Why was FY23 so bad?

Rising inflation, which led to central banks lifting interest rates, put the thumbscrews on smaller companies, who saw their cost of capital skyrocket. That’s according to Luke Winchester of micro-caps focused fund manager Merewether Capital, who adds that: “The uncertainty caused a flight toward stocks that offered size and liquidity.”

“It has been an extremely tough time for microcap investors as the majority of companies in the space are still sub-scale, and by definition are small and illiquid,” Winchester says.

But he believes there are now strong – and strengthening – reasons to be hopeful for the future.

Green shoots for micro-caps

Practitioners within the investment space are always emphasising (and rightly so) that past performance isn’t a reliable indicator of future returns. But Winchester makes the point that past returns set the conditions for the future.

He also believes that moderating inflation in the last few months, combined with strong employment and economic growth, has further bolstered the prospect of a soft landing.

“With valuations across the microcap landscape beaten down so heavily, those businesses that can establish sustainable business models and grow their earnings into the future will do extremely well,” Winchester says.

“We’ve seen confidence return to the larger end of the market, which should slowly start to drift down to microcaps.”

Company management’s shifting mindset

Winchester notes that the trend observed in the last couple of reporting seasons – of micro-cap management teams detailing their path to profitability and free cash flow (if they’re not already profitable) – is continuing.

“They’re almost all trying to assure investors they can reach that point without needing to further raise capital and lock in heavy dilution [of existing shareholders],” he says.

“But those microcaps that have shown an ability to generate free cash flow and offer an outlook for growth have been rewarded handsomely.”

A few company examples Winchester provides include:

• Smartpay (ASX: SMP)

• Duratec (ASX: DUR)

• XRF Scientific (ASX: XRF)

• DUG Technology (ASX: DUG).

Note: Of the above companies, only XRF is currently held in the Merewether portfolio.

“The market is rewarding stocks that can generate free cash flow and offer the potential for growth over the next few years in the face of an uncertain macroeconomic backdrop,” says Winchester.

Two companies that are held in his portfolio are detailed below.

8Common (ASX: 8CO)

A provider of expense management software and a virtual expense card application, 8CO is a clear demonstration of the shifting focus of the microcap management teams I mentioned earlier. The business slowly moved towards free cash generation during FY23, before achieving it in the last quarter. It was duly rewarded by the market, the share price climbing in response.

“The future growth of the business was secured in 2021 when 8Common won a whole of Federal Government contracts for the provision of their expense management software,” says Winchester.

“As government departments onboard over time, there will be steady growth in implementation and recurring revenue as 8Common grows from around $4 million ARR today, to $10 million as the Federal Government contract is executed.”

The six-month share price of 8Common (Source: Market Index)

Austco Healthcare (ASX: AHC)

A provider of nurse call hardware and clinical workflow software, Austco has never tipped into a cash-burning position, though difficulties with executing work with hospitals and aged care facilities during COVID meant profits were muted for a few years.

“But with those headwinds now eased and a record backlog in place, as Austco Healthcare continued to win new work, the business is well positioned to grow profits strongly over the next few years,” Winchester says.

He believes the business is well-positioned to achieve $3 million in net profit after tax this year, noting it already trades on a reasonable 16 times earnings multiple.

“But with the large backlog and further penetration of higher margin software products, I expect Austco Healthcare to hit an NPAT of between $4 million and $5 million in FY24,” Winchester adds.

Austco's six-month share price. (Source: Market Index) 

Note: This is based on an article originally published on Livewiremarkets.com on 24 July 2023.